The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

Leave a comment


  1. That´s always true in real life outside central banking. If you are doing your job well so that there are no hassles, deadline misses, etc, others will naturally think you are not working, or working long enough. As soon as you make a string of “mistakes” and then have to work hard to correct them, people will say: “There´s a hard working man, he´s getting “things done”!!!

    • The point is: The Fed made a big mistake in 2008 and then had to take drastic action to “save” the financial system. Ergo, Bernanke is said to have done a great job in avoiding a Second Great Contraction!

  2. Marvellous post Lars. I agree almost totally.
    I think that in 2003-2005, money was expanding too much. ¿Why? because in these years, NGDP grew quite more than the historical trend: 6,8% of average, between 2003 (IQ) and 2005 (IQ).
    The velocity grewnot so much for normal standards.
    The problem was that CPI was running at a higher pace than trend: 3,3% in 2004(06) 2005(09). So, with revised data, monetary policy was too much permissive.
    I think alo that much of these data have been revised onwards, and perhaps Fed cannot be accused of negligance, but ti is incuestionable that the confidence on Fed had raise the margin of tolerence to inflation.

    • Luis
      But don´t forget, and this is important, that between 2003 and 2005 NGDP was growing above trend for the same reason the economy should now be growing above trend, i.e. TO TAKE IT BACK TO TREND!

      • And the higher CPI Headline inflation between 2003 and 2005 was due to the oil price shock (doubled) following the US invasion of Iraq.

  3. Luis, I agree – the Fed’s high credibility probably meant that it was not held accountable initially for overly loose monetary policy in the period just prior to the collapse. I, however, still is uncertain how big the impact of this overly policy was.

  4. Yes, but I see some risk in justifying all deviation from the long term objective as a necessary measure TO TAKE IT BACK TO TREND. How muuch time above the trend to back to it? In 2003, the deviation from NGDP trend was not so high. Taking account the inaccurated character of the data, I don´t know if it is possible to be so precise.
    On the other hand, I don´t know “how big the impact of this overly policy was.” I know (ex post) that there was a residential bubble developing, an overleveraging , and if we are monetarist, we have to admit some responsability of money in it. Or is the money only significant in real markets?

  5. Shahid

     /  November 1, 2011


    its always wonderful to read your blogs. I just have one comment, and i hope you dont mind it. I have noticed a few wording errors, which leave a particular sentence incomplete. For example, in this particular post, there is a sentence “However, lets say that for some reason the money supply growth by 10%”. The word ‘growth’ needs to be replaced by ‘grows’ to make more sense of the sentence. as a friendly advice, you might want to write in word format, which would point out the mistake.
    Again, hope you dont mind. i myself am not very good at tis thing, but since your blog is an international blog, and i am a fan of Monetary economics, therefore i thought i should point it out.

  6. flow5

     /  November 1, 2011

    Nothing ever changed – MVt=PT. PT is a proxy for all transactions. MVt is aggregate monetary purchasing power. For those who need a reminder the equation of exchange is an algebraic way of stating a truism; that the product of the unit prices, and quantities of goods and services exchanged, is equal (for the same time period), to the product of the volume, and transactions velocity of money.

    Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, & for (2) inflation indices, are always historically, fixed in length. However, the FED’s target(s), vary widely.

    Nothing ever “broke down”.

  1. NGDP targeting is not a Keynesian business cycle policy « The Market Monetarist
  2. Defining central bank credibility « The Market Monetarist
  3. The biggest cost of nominal stability is ignorance « The Market Monetarist
  4. ”Regime Uncertainty” – a Market Monetarist perspective « The Market Monetarist
  5. How (un)stable is velocity? « The Market Monetarist
  6. Does Y determine MV or is it MV that determines P? | The Market Monetarist

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